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JKAU: Islamic Econ., Vol. 4, pp. 81'87 (1412A.H./1992


Shaikh Mahmud Ahmad *

Towards Interest-Free Banking Institute of Islamic Culture, Lahore, 1989.

Reviewed by :



Formerly, Director General International Institute of Islamic Economics,Islamabad

This book is of uneven merit. It contains a fairly good accountof the attitudes to- wards the institution of interest through the ages.It also contains a fairly elaborate critique of the various theories of interest which have soughtto justify a return on capital in the form of interest. However, its exposition of interest-free banking is marred by a number of deficiencies which seriously detract from the value of the


The author rightly points out in the first chapter that all great religions have op- posed interest. He then analysesthe arguments that have been put forward from

given to theories which

justify interest on the basisof time preferenceand liquidity preference. Logical con- tradictions in someof the theories of interest are clearly brought out, andsomeof the basic assumptionsunderlying these theories are ably criticized. There is also anin- teresting accountof how even eminent economistsconfusebetweenthe conceptsof interest and profit.

time to time in justification of interest. Special attention is

There is widespread agreementamongMuslim scholarsthat, keeping in view the

injunctions of Islam, the ideal alternatives to interest in anIslamic economic system are profit/loss sharingand qard hasan.Almost all the theoretical contributions onthe subjectof interest-free banking give pride of placeto mutJiirabahand musharakahas

the two

most prominent forms of profit/loss sharingarrangementson whichthe foun-

'Shaikh Mahmud Ahmad passedaway on 22 May 1990at Lahore. He was72. ShaikhMahmud Ahmad

ofIslam in 1947. He remained dedicated to

the causeof Islam and Islamic economicstill the end. May Allah grant him forgivenessand mercyand

reward him for hisservices.

wasamong the pioneers, having published his Economics





dations of Islamic banking canbe raised. It is recognizedthat while profit/loss shar- ing is the real alternative to interest in an Islamic economy, resort canbe taken to other techniques, which are not prohibited in Islam, if the application of the system of profit/loss sharing in certain situations gives rise to specialdifficulties. Some of these techniques are bai muajjal/murabaha (usually translated as cost-plus trade financing or 'markup' finaqcing), ijara (lease or hire), ijara wa iqtina (hire-purch- ase), and bai salam(pre-purchaseagreements).The author of this book, however, takes a different line. He is of the view that "no significant device has beenevolved by Muslims as a substitute for interest" (p. 15):* Muqarabah and musharakahare pre-Islamic arrangementsand "both suffer from identical inapplicability on a major part of the economy" (p. 15).The other techniquesare regardedas"indistinguisable from interest" (p. 15). A little further on, the author assertsthat "the only concept available in Islamic thought which doesnot suffer from either a speckor a stainof in- terestis that of qard hasan" (p. 16).

The author is of the view that "Shirkah and Muqarabah are excellent devicesto

eliminate interest in personaldealings" but ''as soonaswe enter the realm of institu- tional credit, the workability of both theseconceptscontracts, while problems con-

nected with their

lete" (p. 44). The author givesthree reasonsfor the "obsolescence"of muqarabah and musharakah.Firstly, thesetechniquescannotbe applied to provide resourcesto the governmentto cover their fiscaldeficit. Secondly,they cannotbe usedin the case of consumptionloans. Thirdly, "even in the caseof productive loans, the number of

borrowers precludes supervisoryarrangementsunder either of thesetwo concepts"

(p. 45). While summarily dismissingmuqarabah and musharakah as viable substi-

tutes for interest on suchreasoning,the author takesno no,ice of the extensiveliter- ature on interest-free banking which contains answersto his concerns.None of the writers on interest-free banking has taken the position that all the operations of in-

terest-free banks haveto be conducted on the basisof muqarabahand musharakah. It is generallyagreedthat, in aninterest-free economy, someresourcesof the bank- ing systemwill be set apart for beingprovided on qard hasanbasis.The rationale for the provision of someresourcesof the banking systemto the governmentin the form of interest-free loanshasbeensetforth in manywritings. (I)The justification, briefly, is that banks will pay no return on demand deposits in an interest-free framework and should be expectedto make someresourcesavailable to the government to fi- nance socially necessaryprojects on interest-free basis. Moreover, unlike the posi- tion taken by the author, the possibility of using the techniquesofmuqarabah and musharakahin financing a part of governmentexpendituresis not ruled out by other writers. It has rightly beenpointed out by thesewriters that thesetechniquescanbe usedtoiinance suchpublic enterprisesasareexpectedto yield a reasonableprofit. (2) The residualrequirements of the government canbe met by interest-free loans from the central bank of the country.

application multiply, rendering both theseconceptsvirtually obso-

"Here andelsewherepage numbersin parenthesesrefer to the book under review.

I. See,for example,M.U. Chapra, (1985),pp. 161-163.



The literature oninterest-free bankinghasalso dealt with the mechanismsthat can be used to meet the loan requirements for consumption purposes. It has been pointed out by many writers that ideally the provision of consumptionloans to the needyshould be the responsibility of the socialsecurityapparatusof the state.(3)A li- mited amount of suchloans canalso be provided by commercial banks to their ac- count holders for which a servicecharge anbe recovered.(4)Writers on interest-free banking see no difficulty in organizing a systemof finance for those who wish to purchaseconsumerdurables on installment paymentsbasis.Interest-free banks can provide finance to firms engagedin the businessof instalment saleson profit sharing

basis. (5)

The author regards mutJarabahand musharakahasunworkable substitutesfor in- terest in the caseof productive loansbecauseof the difficulty of making supervisory arrangementsto covera large numberof borrowers. There is no denyingthe fact that banking on the basisof profit/loss sharing (PLS) entails greater supervisioncom- pared to interest-based banking. However, given adequate staff and appropriate supervisingtechniques,there is no reasonwhy the PLS systemshould not be able to deal with a large clientele. The degreeof supervisionneededin mutJarabahfinancing is minimal becauseof the very nature of a mutJarabahcontract. Financing on the basisof musharakahalsodoesnot necessarilyinvolve too detailed a supervisionover the affairs of the usersof suchfinance. In the caseof well establishedfirms with good businessreputation, there will hardly be any need for the financing bank to set up elaborate supervisoryprocedure~.In caseswhere a needexists for greater monitor-

ing, appropriate supervisorytechniques can be worked

writers on interest-free banking that costsof monitoring would be higher in the case of PLS systemcomparedto the interest-basedsystem.However, they also point out that thesecostsare likely to be more than offset by the increasedprofitability of PLS

systemunder normal circumstances.

out. It is acknowledged by

The author regardsthe other financing techniquesbeingusedby Islamic banksas subterfuges, indistinguishable from interest, devisedto evolve somemethod of re- warding capital (p. 15).There is agood deal of literature now onthe controversysur- rounding these other financingtechniques.Though very fewsharethe viewof the au- thor that thesetechniques are indistinguishable from interest, mostwriters caution againstwidespreaduseof thesetechniquesbecausethey are not capable of making any significant contribution toward achievement of the objectives of the Islamic economy.(6)The financing technique known as bai al-muajjal has aroused greatest controversy but even in this case,asthe author himself acknowledges,a number of fuqaha (Islamic jurists) have acceptedits validity (p. 45).

While discussingthe various financing techniques,the fuqaha have laid down the

3. SeeM.N. Siddiqi, (1982),p.34.

4. SeeM. Mohsin, (1982),p. 193.

5. SeeM.U. Chapra, (1985),pp.130-132.

6. See,for instance,Abbas Mirakhor, "Short-term Asset Concentrationand IslamicBanking" in Mohsin

S. Khan and Abbas Mirakhor, eds. (1987).




conditions that must be fulfilled to ensure that they conform both to the letter and spirit of Islamic teachings. A large number of Islamic banks operating in different countries have a Religious Supervisory Board so that managementsof banks can have easyand continuous accessto religious scholarsfor consuJtationsin evolving the operating proceduresof the banks, and the scholarsin turn have full opportunity of scrutinizing their actual operating procedures. In the absenceof sucharrange-

ments, there is a risk that someof

Islamic norms. This is in fact what hashappenedin Pakistanwhere someof the prac-

tices adopted by banks during the courseof the switch over to interest-free banking have beencriticized by religious scholarsfor their not being consistentwith the spirit ofshari'ah. (7)The author of the book under reviewhasrightly drawn attention to the objectionable features of thesebankingpractices(pp. 46-47)but heis wrong in his as- sertionthat "IsJamiceconomistsasa body in their International Monetary and Fiscal Conferenceheld in Islamabadin 1981gaveth~ir unreserVedapprovalto this arrang.e- ment" (p. 48). The fact is that the Islamic economistsgathered at that Conference

complimented the Government of

the intensive work done to find waysand meansof eliminating riba and commended (he Report of the Council as a historic document, but they had no opportunity to look into the actual operatingproceduresof banksand did not therefore expressany opinion on suchprocedures.(8) In the secondchapterof the book, the author puts forward his own modelof anin- terest-free banking structure. He builds his model on the premise taht "time is as much an ingredient of a loan asthe loan itself'. He explains this further by stating that "what the lender foregoesand the borrower receivesis not merely an amountof loan but an amount of loan for a certain period of time". He then sets forth a hypothesis: "If we multiply the amountof loan bythe period for which it is advanced, we getthe measureof deprivation suffered by the lender which is alsothe measureof gain received by the borrower". He givesthis magnitude the nameof "loan value" He then proposesthe establishmentof aninterest-free banking systemon theprinci- pIe of equality of "loan values". Specifically, what the proposalamountsto is that if a person needs loan for any purpose from a bank for a certain period of time he should also give loan to that bank in ancamountsuch that the "values" of the two loans are equal. For example, if a personneedsa loan of Rs. 1,000for one year he should give a loan of, say, Rs. 100 for ten years to the bank. At the expiry of the statedperiod both parties will repaytheir loans in original. This is the essenceof what the author callsTime-Multiple Counter-Loan (TMCL) ba~edinterest-free banking. The third chapterof the book discussesthe modalities of achangeover from interest- basedbanking to TMCL model of interest-free banking. In the final chapterthe au- thor seeksto answerpossibleobjections to his model.

The author is aware that availability of bank loans atzero rate of interest, aspost-


operating proceduresmay not conform to the

Pakistanand the Council of Islamic Ideology for



in this














(1985),esp.See the communiquepp.


at the end

of the Conference

of Islamic


m Zlauddm








Shaikh Mahmud Ahmad: TowardsInterest-FreeBanking


ulated in his model, will result in a steeprise in the demand for bank loans. He prop- osesto meetthis situation by the abolition of statutory reserverequirement which he considersan unnecessaryrestraint on the credit creating capacityof the banking sys-

tem. He concedesthat eventhis may not

for bank credit. So he proposes that banks should not grant any loans for non-pro-

ductive purposesandoShouldalso not advanceanyloans for covering the budgetary deficit of the government. Besides,they will be able to borrow from the central bank

of the country to meetthe additional demand for

In suggestingsuchsolutions to the problem that may arise consequentto the adop-

tion of his model, the author seemsto be oblivious of the dangerof excessivecredit

expansionby banks. The author seemsto believe that there is no

flation being causedby credit creation asthe monetary demand generatedby credit creation will be absorbed by the increasein production both on accountof full utili- zation of the previously existing idle capacity and increments to the productive capacity of the economy. This is obviously a highly over-simplified approach to a very complexquestion. The argumentemployed by the author assumesthat there is anunlimited supply of real capital available in the economy. The fact of the matter, however, is that mostcountries, and particularly the developingcountries, facea big problem of shortageof real capital. This shortageof real capital cannotbe remedied by credit creation becausebank credit only gives command over real resources; it cannpt create real resources.Once it is realized that the capacityof an economyto produce goodsand servicesis constrained by the availability of real resources,which in turn is dependent on a host of factors suchasthe savingrate of the economyand availability of foreign exchange, one has to admit that unrestricted availability of bank credit at zero rate of interest can pose a serious threat of inflation to an economywhich adopts TMCL model of interest-free banking.

It should of coursebe possible evenin a TMCL model of bankingto guard against inflation by imposinga limit on overall credit expansionthrough central banking ac- tion. However, once the need for keeping credit expansionwithin certain limits is recognized, the question of the optimality of various options available assumesim- portance. In the interest-basedsystem,the equilibrium betweenthe demand for and supply of loanablefunds is soughtto be achievedbyvariations in interest rates. Writ- ers on Islamic banking have shownthat replacementof interest by a systemof profit! .loss sharingis a more efficient way of bringing about a balancebetweenthe demand for and supply of bank funds. The argument essentiallyis that in the interest:'based systemthere is no inbuilt incentive on the part of banks to give priority to ventures with the highest profit potential, while in a systembased on profitlloss sharing re-

enable the banks to meet the full demand

bank on the sameTMCL principle.

dangerof undue in-

sourcesare likely to flow to mostprofitable ventures which is aplus factor for alloca-

tive efficiency. The

cerned more with the safetyof the funds lent rather than the profit potential of ven- tures, and is thus opento the samecriticism asthe interest-basedsystemfrom the vie- wpoint of allocative efficiency.

TMCL model also, like the interest-basedsystem, will be con-

From the viewpoint of equity, the TMCL model canhardly qualify asa seriousal-

ternative to interest-based banking in an Islamic economy. Islamic

banking is ex-



pected to not only avoid transactions on the basisqf interest, but also to participate actively in achievingthe goalsandobjectivesof anIslamic economy. Reduction in in- equalities of income and wealthfigures asanimportant policy objective in anIslamic economy. The TMCL model, insteadof being of any help in this respect, will in fact serve to aggravate inequalities of income and wealth. Depositors in the TMCL model would get no return on their depositswhile borrowers will not have to part with any part of their profits. A large number of depositors belongto lower income groups, including the weakestsectionsof the population suchasretired people and widows, while borrowers are mostly businessmenbelongingto the most affluent sec- tions of the population. Replacementof interest-basedbanking by TMCL model of interest-free banking would further enrich the richer sectionsof the population and penalize comesand the wealth. weaker sectionsof the societyand aggravatethe maldistribution of in-

It is well known that while any return on capital in the form of interestisprohibited

in Islam, there is no objection to getting a return on capital under profitlloss sharing arrangementsapproved byshari' ah. There is no reasonwhythe author shouldbe op- posed to giving any return to the depositor.sin an Islamic banking system even though they are prepared to take the risk of a loss in capital. It is really strange that while the TMCL model of interest-free banking presented by the author envisages

banks earning "profit

yield" by "direct productive investment" of funds (p. 85) accruing to the banks through counter-loansand credit creation, it denies any return to depositorswho in fact enable the bank to earn suchhigh profits. In fact, the TMCL model richly re- wards a small band of shareholdersof the bank and leaves the large body of de-

exceeding even those that present pattern of banking can

positors high and dry!.

For guarding the stability of the banking systemunder his proposal, the author suggeststhat "a collateral of 110 per cent of the loan should be demanded for all loans" (p. 59). The author doesnot seemto be concernedwith the distributional im- plications of suchanarrangement. Other writers oninterest-free bankingemphasize

that it

of the collateral syndrome. It is due to the insistenceon the collateral that financing by interest-based banks gets dir~cted mainly to the rich. Banks in an Islamic economyare expectedto help in achievingthe Islamic socio-economicobjective of providing equalopportunities for material advancementto all sectionsof the popula- tion. This requires Islamic banks not to be guided by the collateral but by the sound- nessof the businesspropositions in their financing operations. The TMCL model of interest-free banking presentedby the author seeksto eliminate interest from bank- ing transactions but, by continuing emphasison the collateral, retains one of the

mustbe one of the foremost objectives of anIslamic banking systemto getrid

mostobjectionable features of interest-basedbanking from the Islamic viewpoint.

The book contains a number of highly oversimplified and unsubstantiatedstate- ments.The author attributes economicsuccessof Switzerlandand Germanyto lower bank rate (p. 17). He doesthis without examiningthe possibility that lower bankrate may in facthave beena consequenceof the successachievedby thesecountries in av-



maintaining a strong balance of payments posi-

tion. He claims that TMCL model of interest-free banking has a "built-in arrange- ment to help any economyto outgrow both unemployment and inflation" (p. 83). The arguments employed to prove this claim are hardly convincing. The author seemsto believe that elimination of interest will bring about suchan increasein in- vestment that the labour force will be fully employed. This line of argumentdisre- gardsthe objective realities that investment may not be sufficiently interest elastic in many situations, particularly in situations of shortageof real capital and absenceof sufficient wageprice flexibility.

Is TMCL model of interest-free bankingcompatible with shari'ah?This is a debat- able issue.The author claims that TMCL model is institutionalization of qard hasan and "there is no doubt about the permissibility of the conceptfrom the Islamic point of view" (p. 135). However, asthe authorhimself notes, reservationshave been ex- pressedabout the counter-loan aspectof the TMCL conceptby Islamic scholars.

The author claims that "the TMCL conceptcar)be regardedthe only viable, work- able and feasiblesubstitute for interest" (p. 87). This is anunjustified statement. Ex- perience has shown that Islamic banks have to employ a variety of financing mechanismsto operationalize the conceptof interest-free banking.

oiding high budgetary deficits and


Chapra, M.U. (1985) TowardsaJust MonetarySystem.Leicester: The Islamic Foundation. Governmentof Pakistan, (1985) Pakistan Economic Survey,1984-85,Islamabad.

Mirakhor, Abhas, (1987)Short-Term Asset Concentration and Islamic Banking, in: Khan, MohsinS. and Mirakhor, Abbas (eds.) TheoreticalStudiesin Islamic Banking and Finance,Houston: The Insti- tute for Researchand Islamic Studies. Mohsin, M. (1982)A Profile of Ribii-Free Banking, in: Ariff, M. (ed.), Monetaryand FiscalEconomicsof Islam,Jeddah: International Centre for Reserchin Islamic Economics. Siddiqi, M.N. (1982)Islamic Approaches to Money, Banking and Monetary Policy: A Review, in: Ariff,

M. (ed.) Monetaryand FiscalEconomics ofIslam,Jeddah: International Centre for Researchin Is-

lamic Economics. Ziauddin Ahmad, etal. (eds.) (1983) Fiscal Policyand ResourceAllocation in Islam,Islamabad: Institute

of Policy Studiesand International Centre for Researchin Islamic Economics,Jeddah.